What’s QE all About Anyways? (or Why it’s too Early to Buy the Banks or Bank Assets)

Yesterday, following an interview on BNN we received quite a bit of email in response to the remarks I made on-screen regarding Mr Bernanke’s policy of Quantitative Easing (QE). There seems to be a great difference of opinion, and we might add, confusion, as to what this program actually entails and why it is being pursued.

The announced aim of QE is to raise asset prices above their market clearing levels in order to add a fillip to growth prospects in the US.  Ben Bernanke, speaking recently contends:  “I think we are underestimating and continue to underestimate how important asset prices, very specifically equity values are, not only for shareholders and the like, but for the economy as a whole.” 

The proposition that Monetary Policy can exert a growth impact on the real economy through an asset channel, AND that it will be significant,  AND that the Fed can predictably control this effect within reasonable tolerances and timeframes as contemplated by Bernanke, is highly speculative at best. One needs only to review the available literature in this area or to do the math on the potential impact of the announced QE program to arrive at this conclusion. Once past the hurdle of needing to treat the Fed Chairman’s pronouncements with a dose of healthy scepticism, and given the size of the intervention, the obvious conclusion one must draw is that the intended effect of QE is perhaps directed at certain other policy objectives that the Fed deems to be at least as important as raising employment and economic growth prospects. Bernanke’s recent admission that unemployment would remain high until at least 2014/15 – essentially saying to the unemployed “There is nothing we can do for you folks beyond issuing dole checks” –  underscores this interpretation.

There are in fact three interlinked goals of QE in combination with ZIRP (Zero Interest Rate Policy). The first has to do with the condition of bank balance sheets; the second with the condition of the Fed’s balance sheet and the last with the funding requirements of the US Government.

 Bank Balance Sheets

The FDIC Claims that it has 860 banks on its watch list, the most since the S&L debacle which occurred almost 30 years ago. As a regulator/policymaker there are three things that you can do in a situation where you have failing banks on your hands:

 (1)     Liquidate the banks – Fire everyone; sell of the good bits and manage down the junk. Prosecute the criminals and fraudsters

(2)     Put into receivership or conservatorship –  Fire management. Restructure Business and off to the races again. Prosecute the criminals and fraudsters

(3)     Subsidize – Give money to fix TEMPORARY Problems. Everything else stays the same. This assumes that the business is basically healthy and there has been no accounting control fraud.

 …..and to execute any one of these strategies you need to ensure the following Best Practice Guidelines are met:

(1)     Transparency. Ensure that the markets understand what is going on i.e. how bad the issues are and what the intended results are

(2)     Assertiveness. Need to act aggressively and with purpose to stem the problems in the early stages

(3)     Accountability. Hold executives etc responsible and measure performance during the restructuring , liquidation or subsidy period.

(4)     Clarity. Explain the markets EXACTLY what forms of assistance that the banks are getting and why

We have written in that past about the fact that the zombie bank problem is much, much larger than what the authorities have been telling the markets. In fact we estimate that the scale of the problem in the US is on the order of USD 500 to 700 billion dollars. Therefore what is being attempted in the US (and in Europe) to cure the zombie bank problem is a stealth subsidization approach complemented by liquidation of only the most rotten of the zombie banks (e.g. in the US those banks, for example, that have a gross asset impairment ratio of over 20%). In pursuing this policy the Fed, the OCC and FDIC have implicitly adopted an approach that assumes that the institutions are basically sound and all they need is a bit of money and some time and the problems will take care of themselves. In fact the chart below shows that the Fed’s usual trick of lowering the Fed Funds rate opening a wide spread against term rates and thereby allowing the zombie banks to re-capitalize themselves by riding the curve is not working at all as well in the present situation as it has in past years. This is why QE, which gives the banks more cash to play with, is being aggressively pursued.

The effort to keep the true condition of banks cloaked also explains why the US authorities suspended (without formal announcement) the application of the “Prompt Corrective Action Law“ and strong armed the FASB into striking down the mark to market rules allowing insolvent institutions to continue to “mark-to-fantasy” and avoid liquidation. These policy actions are all related to maintaining the impression that almost all banks in the US are still healthy. Recall that our view of the Bank Stress Tests in the US (and Europe) is that they were designed to make the banks appear to be sounder than they really are. In the case of US banks, the stress tests did not properly stress real estate risks; and in the case of the European test, it was Sovereign Debt exposures that got the once over lightly treatment. Look at where we are today. How credible do the test procedures seem now in the wake of renewed concerns regarding the European Sovereign Debt situation and persistent weakness in US housing markets and the looming rollovers of commercial real estate loans there?

Hence we can infer that similar objectives have lain behind the refusal of banks and policymakers in Europe to consider debt write downs. This is why the bailout packages being forced onto the peripheral European countries are considered to be very rickety solutions in our opinion. They do not accommodate the needed reckoning and write down of the bad loans made by banks to those economies, pile more debt onto them that is then expected to be funded by taxpayers who, as a consequence of the situation, effectively become tax slaves.  This situation is not socially nor politically stable in the medium term, and certainly will not last long enough for these economies to dig themselves out of the mess by using these means. Refer to our previous comments on the history of fiscal remediation efforts.

(Compare the actual actions of the authorities as described to the Best Practices Guidelines shown above)

As long as the banks remain weak, look for the US authorities to maintain their “extend and pretend” policies; and look for QE to make another encore appearance. (Similar motivations, namely the need for a blanket solution to the Sovereign Debt Crisis in Europe is why the European Central Bank has just re-started its QE program.)

What would we have done? See here.

The Fed and the Treasury

There are two other reasons for running the QE, namely to help the Fed and the Treasury to dig themselves out of the holes that they are in:

The Fed needs to find a way out of the “roach motel” it created for itself when it re-discounted toxic waste from the market at par (instead of market value)  to keep the worst of the insolvent banks afloat, and when it bought back huge MBS inventories from Fannie Mae and Freddie Mac. The “elevator boots” afforded by its ability to massively leverage its footings without regard to capital considerations or credit risk are certainly helping it achieve this objective. Recent disclosures by the Fed regarding its lending operations and counterparties do not tell the entire story. Moreover, the fact that the Fed is not, and never has been, subject to mark-to-market rules or disclosure requirements as to its activities, in theory allows it to play this game until the combination of money printing and yield curve trading covers its internal asset valuation deficit. The fact that the QE undertaken so far is insufficient to cover this shortfall is one more reason why we will likely continue to see additional QE after this round is completed.

At 14.5 % of GDP, US Federal Tax revenues are off sharply from the usual 18-19% run rate. In combination with the various stimulus measures and entitlements ramp up, this has opened up a huge funding requirement. The Treasury needs a helping hand to fund its deficit as it is becoming clear that there is significant congestion in US bond markets as evidenced by recent price action and the withdrawal of foreign players from the buy side. There is in fact more than some reason to believe that the Treasury does not want to expose itself to funding risks because they want to maintain the fiction that they have no problem closing the deficit. Recent results of the coupon passes show that on-the-run bonds are being submitted back to the Fed, and thus even the pretence that these operations are not designed to monetise the deficit has evaporated. The Chinese for their part laid down the gauntlet a month ago when Dagong Credit Rating Agency downgraded the US to A+ with a negative outlook. “Who listens to Dagong?” one might ask. The answer is that they only need one client – the Chinese Government – and if the ratings threaten to fall below single “A” (the typical investment cut-off for central banks and Governments); what that client does or what it tells the market in intends to do with its holdings of US dollars and US Treasury debt is of vast significance. By way of this indirect method, the Chinese are showing the US that they are in possession of some pretty big political and economic levers. We know the Chinese are upset with the QE and the “meddling” by the US as regards the yuan/US exchange rate. How this policy tussle shakes out is something that we will be watching with interest. Finally, the fact that there is at present almost no recognition among the US leadership that the US needs to get its fiscal house in order is a third reason that adds to the probability that the continuation of QE beyond the current program is very likely.

 Risky Business

Note that the dangers of the QE and ZIRP stance are substantial and numerous. These include growing geopolitical tensions, social unrest, the intensification of imbalances and fiscal stresses in emerging and other economies, rising inflation and a loss of credibility for the Fed. Moreover, far from being a set of policies solely designed to re-start the economy, the discussion above suggests that the financial underpinnings of the US are on a very precarious footing, that the Fed knows this, and that this is why it has chosen this untested and risky policy path involving QE and ZIRP.

As measured against Bernanke’s announced intentions of lowering the dollar, lowering bond yields, raising stock and property prices, and boosting the economy the QE program must be judged a failure. However, the jury is still out as to whether the Fed will be successful in achieving its unannounced goals as described above, and if in fact QE and ZIRP are the appropriate tools for all of these jobs or just a perilous policy patchwork assembled and implemented in haste.

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